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Looking Beyond the Gateway Markets

Todd Briddell | Jan 25, 2017

Large coastal cities have been a great place to invest in since the global financial crisis, and there’s good reason why. Companies focus on these cities in search of the best talent. People want to live in these urban cores, drawn by the diversification, culture and opportunity. And because investors understand these factors, real estate assets in these cities have retained strong pricing even under softer economic conditions.

However, gateway markets have become the victims of their own success and are now facing some challenges. It may be time for investors to break with the post-crisis trend and embrace the broader opportunity in non-gateway major markets. Here’s why:

Supply is moderating cash flow growth, decreasing the pricing power of landlords in gateway markets. It’s a paradox of this real estate cycle that the “hard to build” markets—those most densely populated—are becoming those with the most new supply, particularly over the last two to three years.

Yields are low and the yield gap is wide. Right now, the yield gap between gateway and non-gateway markets is at an all-time high. The current capitalization rate spread is 165 basis points compared to the long-term average of 117 basis points, which means gateway markets are trading at historically rich valuations relative to non-gateway cities. Net operating income growth is slowing relative to lower barrier markets, leaving gateways vulnerable to some underperformance going forward.

Good evidence from the REIT marketis materializing. Although the REIT market may overreact to negative or positive shifts, it tends to be a useful forward indicator of any change in the direct real estate market. Currently, the REIT market is forecasting moderate returns going forward because of the diminishing valuation differential between gateway and non-gateway REITs. The spread that had emerged in favor of gateway markets since the crisis has eroded over the last 12 months, in response to more supply hitting markets like New York and San Francisco.

The evidence for pivoting investment toward non-gateway markets is substantial, but you don’t have to consider tertiary markets when seeking the greatest growth potential. Metropolitan areas such as Phoenix, Denver and Philadelphia are ripe for higher risk-adjusted returns through prime quality, cash-flowing assets. Phoenix’ office market is slated for growth with strong employment and demographic drivers, as well as attractive fundamentals. Denver’s strong, highly educated demographic and diverse economy create a sweet spot for retail real estate, while Philly’s industrial sector is supported by both its strong transportation infrastructure and proximity to large population centers.

Each of these cities offers what investors should be looking for: diversified and strong employment and population growth, limited supply pipeline and pricing below replacement cost. That’s why the opportunity for an investor’s marginal dollar may be most easily found in non-gateway major markets with greater growth potential and that are priced more attractively than the few cities that have so far garnered all of the attention.

Todd Briddell serves as CEO and chief investment officer with CenterSquare. Any statements and opinions expressed do not necessarily represent the views of CenterSquare or BNY Mellon.